Making aggregate demand simple(r)

Aggregate demand (and supply) can be relatively complex concepts for students. 

I was teaching AD one day and thought about how when we talk about aggregate, we’re focusing on total. So if think about AD we’re thinking about every individual demand curve in an economy added together.

In terms of demand curves, it’s the sum of Dean’s and Daniel’s and Hannah’s and mine and yours and...you get the picture.

This description might help students clarify their understanding. Check out the video below too.

It's the night before HSC Eco (or other big exam)...

...and I think you should stop studying.

Sometimes the temptation can be to keep cramming until the very end. But I encourage you to stop.

I don’t have much science to support it, just experience. I think that the brain has a finite capacity, particularly right before a stressful test. There’s a limit to what can be absorbed. You can read and revise notes and highlight — but in terms of whether it will actually sink in...I’m not sure. 

The other reason to stop studying is to ease some of the stress. Maybe you feel less stressed studying. But maybe it would be easier to switch off for a few hours, relax and take some pressure off before the day of the test.

This screams Year 12 for me.

Let’s rewind to my Economics HSC exam, many decades ago. I remember I shocked my classmates because I watched an episode of Dawson’s Creek on TV the night before our Eco exam instead of doing last minute study. This was an ancient time when if you missed a show, you really missed a show. And I was an enormous Dawson’s fan.

If you’re sitting the 2019 NSW Economics HSC tomorrow, or subsequent Eco HSCs or massive exams, good luck and maybe take the night off.

What next for the world economy?

Quick question: over the last 50 years, how many times has the global economy experienced negative economic growth?

So, over the last half century, how many times has the global economy contracted?

Just once. During the Global Financial Crisis of 2008/09. Just check out this graph from the Financial Times.

This is an extraordinary development. Despite oil shocks, debt crises (Latin America and Greece), the Asian Financial Crisis and various wars, the global economy has kept growing.

But in late 2019, economists have been vocal about potential risks to global economic growth.

A synchronised slowdown

In mid-October 2019, the International Monetary Fund (IMF) downgraded (reduced) its forecasts for global growth. The IMF forecasts that global growth to fall to its weakest pace since the GFC.  

Just look at the language the IMF used:

“The global economy is in a synchronised slowdown and we are, once again, downgrading growth for 2019 to 3 per cent, its slowest pace since the global financial crisis. Growth continues to be weakened by rising trade barriers and increasing geopolitical tensions.”

In terms of figures, the IMF forecasts that the world’s advanced economies will grow by 1.7 per cent in 2019 (compared to 2.3 per cent in 2018). Growth in emerging and developing markets has also been downgraded to 3.9 per cent in 2019 (from 4.5 per cent in 2018). 

Monetary policy might be working

There has been some debate about the effectiveness of monetary policy (central banks’ use of official interest rates to boost economic growth) in economies around the world. But the IMF says the use of MP has been very helpful.

According to the IMF, if governments around the world had not loosened monetary policy (reduced official interest rates), global growth would currently be 0.5 percentage points lower in 2019 and 2020.

So, what happens next?

The IMF would like to see governments to do more to improve the state of the global economy. This includes removing trade barriers and ending the trade war, and implementing expansionary fiscal policy, particularly involving additional investment in infrastructure. In Australia, the Reserve Bank of Australia has been arguing for the latter. 

The IMF is clear: now is the time to act. “The global outlook remains precarious with a synchronized slowdown and uncertain recovery. At 3 per cent growth, there is no room for policy mistakes and an urgent need for policymakers to support growth,” the organisation says.

We’ll have to see how the governments respond.

Taking a long look at short answers

In the NSW Economics HSC exam, short answer questions constitute 40 per cent of the marks on offer. 

For context: this is the same weighting as the two extended response questions. So it’s hard to do very well on the exam without performing to a high standard on the ‘shorts’.

Short answers are difficult. Students must be precise because no half marks are given. I find that students get frustrated in terms of how they should structure their responses. Do they need definitions? Stats? Quotes? Graphs? Should they write just the amount of lines or go over? 

“I no longer give students ‘model’ answers...what I find useful is giving students an idea of how to approach specific questions; to give them a process.
”

Initially, I’d deal with this frustration by giving students ‘model’ answers for this section. I’d write carefully crafted responses that went into substantial detail. I don’t do this anymore. This is because short answers can be answered in myriad ways. Also, questions are rarely asked in identical ways, so what’s the point in receiving a ‘model’ answer?

Instead, what I find useful is giving students an idea of how to approach specific questions; to give them a process. I work with them in class to list bullet points of what we could include in a response, including relevant theory and evidence. My hope is that, over time, this process will give them the confidence to attack whatever short response they’re given.

I’ve included links below to my walk through of the 2016 HSC Economics short answer section (parts one and two). This will give you a good idea of my approach with students...and my refusal to provide sample answers.

Some other ideas for students:

• Definitions might be relevant. Be guided by the scope of the question.

• Stats are useful. Look for opportunities to provide relevant evidence, even in relatively small mark questions.

• Quotes are probably better suited for essays.

• Graphs can be super relevant. Consider them particularly for trade protection questions.

• Absolutely go over the lines provided. Provide more rather than less.

Monetary Policy update: October 2019

Australia’s cash rate is now 0.75 per cent. If this seems low, it’s because it absolutely is.

Think about it this way. During the worst of the Global Financial Crisis in 2008/09, the LOWEST the cash rate reached was 3 per cent. 

Is Australia in a worse position than during the GFC? I’m not sure this is correct. The global risks (the ‘downsides’ to global economic growth) don’t seem as bad as during the GFC. But there still are risks to domestic and global economic growth.

Let’s have a look at three reasons why the Reserve Bank of Australia decided to cut the cash rate to 0.75 per cent in October 2019. They’re taken from the RBA’s statement following the October decision.

Reason one: the RBA is worried about the state of the global economy

In its decision to cut the cash rate in October, RBA Governor Phillip Lowe stated that the risks to the global economy “are tilted to the downside”.

Part of the reason? The current trade war. As Dr Lowe says: “The US–China trade and technology disputes are affecting international trade flows and investment as businesses scale back spending plans because of the increased uncertainty.”

The fear is that the global economy growth will slow and this will drag Australia’s economic growth lower. Cutting the cash rate is a move to support domestic growth in this uncertain environment.

Reason two: the Australian economy is growing slowly

Here’s Dr Lowe’s concern: “The Australian economy expanded by 1.4 per cent over the year to the June quarter [2019], which was a weaker-than-expected outcome.” Given this, the RBA believes it’s appropriate to have a more expansionary monetary policy stance to speed up the economy.

But, overall, the RBA identifies a number of elements that are positive for Australia’s economic growth. “The low level of interest rates, recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some established housing markets and a brighter outlook for the resources sector should all support growth,” Dr Lowe said.

So. Some positive signs, but not enough to keep interest rates on hold.

Reason three: the RBA thinks domestic unemployment is too high

The RBA is worried about rising unemployment and low wages growth. 

As Dr Lowe said: “forward-looking indicators of labour demand indicate that employment growth is likely to slow from its recent fast rate. Wages growth remains subdued and there is little upward pressure at present, with increased labour demand being met by more supply.” 

By cutting the cash rate, the RBA is hoping to stimulate aggregate demand, boost the demand for goods and services and thereby boost the demand for labour (aggregate demand).

So what happens next?

Not sure. The RBA is likely to stay on hold in November but some economists expect another rate cut before the end of the year. 

Also, what about fiscal policy? Many economists are calling for the federal government to move fiscal policy to an expansionary stance to match the RBA’s expansionary monetary policy stance.

Distinguish between advanced, developing and emerging economies

Let’s cut to the chase here.

Advanced economies: wealthy, industrialised nations. These countries have left agricultural-based production behind a long time ago. They have even moved past a focus on manufacturing and now have economies focused on services and high-tech industries. They typically have low and slow birth and population growth rates. In fact, they may rely on migration for labour force growth.

Developing economies: relatively poor, agricultural-based economies. Tend to rely on foreign aid. Their political institutions, such as governments, tend to have issues (such as corruption) which can reduce people’s living standards. Very high birth rates and population growth — especially compared with advanced economies. They have not industrialised and their labour force is generally not very productive.

Emerging economies: rapid growing economies like China and India. They’re industrialising rapidly and leaving agricultural production behind. Typically, their focus is on manufacturing (very true of China). Their citizens having rising incomes but inequality is also on the rise. Emerging economies are also seeing rapid increases in foreign investment as people around the world want to benefit from their growth and development.

A potentially tricky BoP question

The 2018 NSW Economics HSC exam was full of challenging multiple choice questions. Here’s one that involves the Balance of Payments (BoP).

Check out the question below:

Source: NESA, 2018 Economics HSC

Let’s consider what we’ve got. From the question we know that we need to focus on Australia’s BoP, not the foreign country (whoever it is).

First bit of info: an Australian company purchases a foreign company.

This involves funds leaving Australia. And because it involves the purchase of a foreign company, this is likely to be a large amount of money. And and because it involves the purchase of a whole company, it is going to be classified as foreign direct investment (FDI).

FDI is recorded on the financial account. Therefore, this first bit of info would be recorded as a debit on the financial account. 

Second bit of info: this foreign company then pays dividends to Australian shareholders.

Dividends are classified as an income flow. This means they are recorded on the current account, under primary income. If the dividends are paid to Australian shareholders, this represents an inflow (or credit) to Australia’s current account.

Then, this second bit of info would be recorded as a credit on the current account.

Our answer is A.

My working out process. See suggestions below.

My recommendation

Exams can be tricky situations. It can be easy to get the answer categories mixed up. I’d suggest working through the question first, putting your thinking down on paper, and THEN looking at the answer categories.

This way, you’ll know what you’re looking for and might be less likely to get tricked.

First time in my lifetime: a current account surplus

June 1975. Australia records a current account surplus.

September 2019. Australia records its next current account surplus.

This is an interesting development for the Australian economy. But, before we look at why this matters, let’s discuss what this all means.

Current account: the economic theory

Australia’s current account is part of the Balance of Payments (BoP). The BoP records transactions between Australia and the rest of the world. It’s a major measure of the nation’s external stability — Australia’s ability to successfully meet its foreign liabilities. 

The BoP consists of the current account and the capital and financial account (KAFA). We’re just focussing on the current account here.

The current account shows inflows and outflows into Australia for trade in goods and services, income flows and other elements (such as transfer payments). Transactions on the current account are non-reversible.

Australia’s long history of current account deficits (CADs)

Between 1975 and 2019, Australia has recorded persistent CADs. This means outflows exceed inflows on the current account. In the graph below you can see the size of the CAD (as a percentage of GDP) between 2000 and 2019 in Australia.

The main causes (or main drivers) of a CAD involve the Balance on Goods and Services (net exports, or BoGS) and Net Primary Income (NPY). BoGS involves payments receipts for exports and imports of goods and services. NPY involves income flows, in and out of Australia, including dividends, rent and interest.

If you look at the graph below from the Australian Bureau of Statistics (ABS) you can see that NPY is usually in deficit. (We’ll go through why in another post.) But BoGS (net goods in the graph below) can fluctuate substantially and swing from deficit to surplus.

Source: ABS. Click the graph to go to the original source.

As of September 2019, BoGS is in surplus to the tune of $20 billion — the largest surplus recorded in Australia’s history. As a result, in September, the current account is now in surplus (a small surplus, $5 billion, but still a surplus).

Why does Australia (currently) have a current account surplus?

The current account surplus is due to the BoGS surplus. But don’t take my word for it. Here’s what ABS Chief Economist Bruce Hockman said.

"Six consecutive quarters of goods and services surpluses, broadly commodity driven, have laid the foundation for our first current account surplus in 44 years,” he said.

Mr Hockman added the export prices AND volumes had risen...while import volumes fell during the same period (potentially due to the depreciating Australian dollar making imports more expensive).

"Export volumes for the key bulk commodities of liquid natural gas, coal and iron ore were up, while volumes fell across several import categories resulting in an increased June quarter trade surplus," he said.

We’ll just have to wait and see if the current remains in surplus or whether this was a temporary event.

GOOD TO KNOW

BoGs is also known as the trade balance. So a BoGS surplus is also known as a trade surplus.

Conflicts between economic objectives

Economics is all about choices, it’s about scarce resources and unlimited wants. You can’t have everything you want, and governments can’t achieve all of their economic objectives at the same time.

In the context of the NSW Higher School Certificate (HSC) Economics course, there are six economic objectives that are examined:

• Economic growth

• Price stability (inflation)

• Full employment (unemployment)

• External stability

• Income and wealth distribution

• Environmental sustainability

Let’s consider three key conflicts in terms of economic objectives.

Conflict one: Economic growth and environmental sustainability

In our economic system, countries mainly use non-renewable resources to fuel their economic growth. They also have a habit of clearing away forests and animal habitats to make way for development. And, in the process of achieving growth, a negative externality (an unintended consequence of production) is pollution.

The more rapidly countries pursue economic growth, the more rapidly they deteriorate the environment. You can think of it as a trade-off. By this logic, lower growth would preserve the environment...but this may also reduce material living standards.

Conflict two: Price stability and full employment

This is a classic economic conflict. In fact, it’s so famous that there’s a graph to describe this precise conflict. The graph is called the Phillips Curve and it looks like this:

Source: Lumen Learning

The Phillips Curve shows that, in the short term, as inflation rises, unemployment will fall. This makes sense as higher inflation is generally a sign of stronger economic activity, including greater consumption and investment (part of aggregate demand), which will lead to greater demand from consumers for goods and services and therefore greater demand from firms for labour (known as derived demand). 

Likewise, when we reduce inflation, we slow aggregate demand (by slowing consumption and investment) thereby reducing firms’ demand for labour and increasing unemployment. 

In the long-term, this trade-off may not exist. But I’ll leave that to your uni lecturers to explain.

Conflict 2a: Economic growth and inflation

This is very much an extension of the points in conflict 2. Put simply, the higher the economic growth rate, the higher the inflation rate is likely to be.

Conflict 3: Economic growth and external stability

This is one of my favourite conflicts, maybe because it’s a bit trickier. Think about it this way: if economic growth is strong, then consumers have higher incomes. They would spend part of this extra money on goods and services, including imports. 

If demand for imports increases, this would likely negatively affect the Balance on Goods and Services in the Current Account of the Balance of Payments (recall that BoGS is equivalent to net exports, or X-M. And in this scenario, the volume of imports are increasing). As a result, the CAD could increase and worsen Australia’s external stability.

To reduce the CAD, and improve Australia’s external stability, a government may need to reduce the demand for imports by slowing the rate of economic growth. This is known as the balance of payments constraint. Hence, higher growth could conflict with external stability.

Yes, there are more conflicts. These are just a few of the more common ones you could refer to.

What is quantitative easing?

Quantitative easing, or QE for short, is complex. Let’s try and simplify it for everyone.

A quick caveat: I’m just taking an overview here. This isn’t the deeply in-depth description your uni professor might be looking for. This is aimed at a high school economics audience.

We’re starting with central banks. If a central bank wanted to speed up or slow down an economy, to achieve its goal of price stability (keeping inflation low, often within a target band), the central bank would affect money supply in the overnight markets. This would lead to changes in the general level of interest rates, economic activity and inflation.

For instance, if an economy has very low inflation, the central bank there might cut the official interest rate (in Australia this is the cash rate; in the US this is the Fed funds rate). But what if the central bank runs out of ammunition and doesn’t have room to cut rates further? What if rates are 0%, or even negative, and the economy hasn’t responded?

Let’s use an example taken from The Economist. During the Global Financial Crisis (or Great Recession for our American readers), America’s Federal Reserve and the UK’s central bank, the Bank of England, slashed rates to spark economic growth. But! Despite rates reaching close to zero, their economies didn’t respond. 

This is where quantitative easing (QE) comes in.

When monetary policy is not effective enough, central banks think about QE.

Here’s the broad process of QE:

• Conventional monetary policy is not working

• Central banks buy securities, such as government bonds, from banks (outside of regular monetary policy transactions)

• This increases money supply in the economy which will push down the general level of interest rates

• The lower interest rates will encourage individuals and firms to borrow more, save less, and increase consumption and investment (components of aggregate demand)

• Economic growth and inflation will increase.

(Again, please note, I’m simplifying this just to share the main concepts at work. If you want to go deeper on this process, particularly how buying bonds will actually reduce the general level of interest rates, try here and here.)

Does QE involve central banks ‘printing money’? Where does the money come from for central banks to buy assets from the banks? This is complex and will be covered in a future blog post. Let’s keep it simple for now.

In September 2019, the European Central Bank (ECB, the EU’s central bank) implemented a form of QE. From November 2019, the ECB will buy €20bn worth of bonds every month — with NO end date to the policy. 

Does Australia need to introduce QE? Reserve Bank of Australia Governor Phillip Lowe has said that the RBA would consider cutting official interest rates to zero AND introducing QE...but he believes that at this stage, as of September 2019, it is unlikely.

And another thing worth thinking about. QE is unconventional. It’s not typical, it’s like an extreme form of monetary policy. So, if central banks are thinking about taking extreme action on monetary policy, why aren’t governments doing the same with fiscal policy?

Australia's employment contracts

In the Australian labour market, there are three main ways of determining wages/conditions: awards, enterprise or collective agreements, and individual contracts. Let’s give you a quick run down on each.

Awards

These are the minimum standards and conditions for a particular job/occupation. They set out minimum rates of pay and the basic level of employment conditions that a worker must receive in their job.

This is a more centralised way of determining wages. Everyone at the same level may receive the same pay and conditions. Some employers pay above-award wages, and this is great news for an employee.

The role of awards is to act like a ‘safety net’ for workers that are vulnerable in the labour market. These workers may be relatively unskilled or inexperienced, and could be victim to exploitation in terms of receiving low wages or unsafe conditions.

Enterprise/collective agreements

These are agreements that apply across entire workplaces or even occupations. They are typically negotiated between unions and employers. 

These agreements are more decentralised arrangements. This is because there is some scope for negotiation between employees and employers. So, employees can agree to work harder (increase productivity) to receive higher wages. Also, employees can agree to trade-off some working conditions for others, or even for higher wages.

We can also see some inequality emerge from this type of agreement. This is because some workers will receive higher rewards than others — even if they’re in the same job.

Please note: enterprise agreements must meet the Better Off Overall Test (BOOT). This means that employees on enterprise agreements must be better off under their relevant agreement than the award. This ensures employees aren’t exploited and trade-off too many conditions.

Individual contracts

These contracts are negotiated one-on-one between employers and employees. They typically apply to high skill, high wage workers who are very valuable and this gives them bargaining power. They can argue for certain wages and specific conditions because they are very valuable. 

These contracts will exacerbate inequality in the labour market as the rewards may be very uneven. A highly skilled worker will command much higher wages than someone relying on the award.

I’m not saying that inequality is a wholly bad thing in the labour market. Inequality encourages people to work harder and help boost output. But it can create additional economic and social issues.

Centralised vs decentralised labour markets

Labour markets are an important concept in economics. There’s one element in particular that can confuse students but you absolutely 100 per cent must be across this: centralised versus decentralised labour markets.

The best way to think about these concepts is to think in extremes. On one side you have a centralised type of labour market...then all the way on the other side you have a decentralised labour market.

To clarify: a labour market is a factor market (market for the factors of production, or resources) where demand for labour comes from firms, and where supply of labour comes from individuals. Equilibrium occurs where the demand for labour meets the supply of labour. And! The price in this market is wages. 

Look at this here image of a labour market:

The market for labour. Notice: demand for labour comes from firms; supply of labour comes from people.

Now, let’s start with a centralised labour market. Here, the wages and conditions of workers are determined by the government. They are determined in one ‘centralised’ location. The government decides the wages and conditions for workers across the economy. 

Just think about the word ‘central’ in the word ‘centralised’. A central location is one, main location where the action happens. 

Jump to the other extreme. A decentralised labour market is the opposite of this. In a decentralised labour market, wages and conditions are determined in many places. They are determined in individual workplaces as unions bargain with employers; they are determined in negotiations between individual workers and their employers. 

In a decentralised system, there is no ‘one’ decision about wages and conditions. Instead, there are many decisions, occurring all across the economy, all the time.

In Australia, we have shifted from a highly centralised labour market to one which is increasingly decentralised. Aside from setting minimum wages and conditions, the government may have no role in determining how much you get paid or what your conditions are. This will be determined in discussions between you, unions and your employer.

There are pros and cons of each system, and I’ll get into these in a future post. But one thing to think about is that in a highly centralised system there is no financial reward for greater productivity. If workers in a company produce more, they are not rewarded with higher wages or conditions as everyone gets the same wages and conditions. So there is no reward for being more productive and helping the economy increase output.

Who pays the tariffs in a trade war?

Trade war! As the United States and China impose tariffs and retaliate with further tariffs, it’s worth asking a question: what’s the economic impact of all this?

You see, if you listen to some people, you might assume that when the US imposes a tariff on Chinese goods, Chinese firms pay the tariff. This is not correct.

First, a little economic theory. A tariff is a tax on imports. It is a form of trade protection that makes imported goods more expensive (less competitive, less desirable) and makes locally produced goods more relatively cheaper (more competitive).

In 2019’s trade war, US President Donald Trump has been vocal about how China is paying for the tariffs. He’s portrayed this measure as a punishment for Chinese producers. But the ones who are really suffering are US consumers and companies.

This is the view of an excellent article by Reuters’ Rajesh Kumar Singh. It’s really outstanding. Here’s what he says about the true impact of the tariffs:

Singh’s excellent article.

“Importers often pass the costs of tariffs on to customers - manufacturers and consumers in the United States - by raising their prices. US business executives and economists say US consumers foot much of the tariff bill.”

And this:

“Stephen Lamar, executive vice president of the American Apparel & Footwear Association, said the new tariffs would hit US consumers far harder than Chinese manufacturers, who produce 42% of apparel and 69% of footwear purchased in the United States.”

Singh goes on to discuss how major stores in the US, such as Walmart and Macy’s, have warned of higher prices for shoppers due to the tariffs on imported Chinese goods. Indeed, Singh cites research conducted by the Federal Reserve Bank of New York, Princeton University and Columbia University that shows US companies and consumers have paid US$3 billion a month in additional taxes because of the tariffs on Chinese goods and global metal imports.

So, what’s the point here? I think it’s important to note that while the goal of the US’ protectionist measures are to punish China, they are ultimately punishing US consumers. This is because, even with the tariffs, consumers need to purchase Chinese goods. There are no viable alternatives. China produces too much of the stuff we need and want. Consumers pay the tax.

Furthermore, by punishing US consumers, this could slow US domestic growth and lead to lower global growth. Which could negatively affect Australia.

“Stephen Lamar, executive vice president of the American Apparel & Footwear Association, said the new tariffs would hit US consumers far harder than Chinese manufacturers, who produce 42% of apparel and 69% of footwear purchased in the United States.”

— From Singh's article.

Inflation is really low in Australia. Why?

Reserve Bank of Australia (RBA) Governor Philip Lowe did a great thing for Eco students everywhere. He very clearly answered this question: Why is inflation so low in Australia? 

I suggest you read the speech and his full text. But I’ll also give you the gist.

(Gist: the substance or general meaning of a speech or text.)

Essentially Governor Lowe cites three reasons for Australia’s low inflation rate (as of July/August 2019). These points are also in the video on the right.

First, Dr Lowe talks about the effectiveness of credibility of monetary frameworks. This is a delicious piece of jargon if I ever encountered one. When we talk about monetary frameworks, what we mean is the inflation targeting part of monetary policy. So, in Australia, the monetary framework involves the RBA’s efforts to keep inflation to between 2 to 3 per cent over the course of the business cycle. 

Importantly, the RBA’s monetary framework is CREDIBLE. This means that people believe the RBA will act to keep inflation in the target band. In this way, people expect low inflation so they will act in a way that causes low inflation. Or, in another sense, they DO NOT expect high inflation, so they won’t yell for higher wages or cause price-wages spirals. Most of the time.

Second, Dr Lowe talks about the presence of spare capacity in the Australian and global labour markets. This means that there is unused or underutilised labour in the Australian economy. So, if firms do need more workers, they can hire from the existing pool — they do not need to bid up wages to attract workers. This keeps wages down and keeps a lid on inflation.

On this point, Governor Lowe talks about how aggregate demand is not growing fast enough to require more workers and reduce the underutilisation rate (the unemployment rate plus the underemployment rate). Faster domestic growth would be helpful to improve the labour market.

Third, Dr Lowe talks about how globalisation and improvements in technology have reduced prices around the world. In Australia, online shopping has increased competition and pushed retail prices down. Better technology means companies can produce more efficiently and reduce prices for consumers. All these factors will result in lower inflationary pressures.

But this doesn’t mean the RBA’s given up on trying to boost inflation back into the target band. Dr Lowe and the RBA have been very clear that interest rates will remain at low levels for some time to try and stimulate the economy (see quote below). 

From the RBA’s August statement after keeping the cash rate on hold. Interest rates low for some time yet.

Talk like an economist

Economics has its own language. In general, I have mixed feelings about jargon. It’s nice to have subject-specific terms that convey a very particular meaning. But jargon also makes things unnecessarily complex.

Either way, jargon is part of economics. And students are expected to understand and apply key economic terms in their written responses. Though it’s not easy. 

I mean, many students get a handle on expansionary/contractionary okay. How about fiscal or monetary easing? What about inflation targeting (or an inflation targeting regime)? And, even worse, what about jawboning?

As a teacher, I wanted my students to feel more confident with this language to ensure they used it in their responses. To this end I recorded a video — split in two parts — that goes through some key (and confusing) vocab.

This is how I’d suggest using this in class.

• Give students this list of terms covered in the video. I cut them up and laminated them for future use.

• Ask students to try and work out the meaning of the terms. Try and avoid them Googling — this defeats the purpose of the task. Put them in teams, resort to pen and paper only. 

• After they’re done, get students to check their understanding through the videos — part one and two.

• Ask the students to evaluate how they performed. Where were the gaps in their understanding?

I don’t make sure students know all the terms before I start. Just throw them in, make them struggle! You might need to leave out some terms. For instance, when I did this activity recently, I left out the term ‘crowding out’. If you try this activity, let me know how you go.

Back to back rate cuts

July 2019, Sydney: the Reserve Bank of Australia cuts the cash rate for the second consecutive month to 1 per cent.

Just for some context, during the Global Financial Crisis, the lowest the cash rate went was 3 per cent. 

Why did the RBA cut rates again? Let’s look at some highlights from the July statement.

Reason number one: Australian economic growth is weak

In terms of economic growth, the goal is around 2.5 to 3 per cent growth in gross domestic product (GDP) annually.

In the year to the March quarter of 2019, the Australian economy grew by only 1.8 per cent. According to RBA Governor Philip Lowe, “consumption growth has been subdued, weighed down by a protracted period of low income growth and declining housing prices.” 

Let’s analyse this quote. One, consumption is weak which leads to weak economic growth BECAUSE consumption makes up around 60 per cent of GDP. Two, low income growth and falling house prices reduce consumer confidence and their incomes, leading to more saving and less spending (because they are uncertain of the future).

So: cut rates, encourage spending and borrowing, and accelerate economic growth.

Reason number two: There’s a lot of unused or underused labour in the workforce

Dr Lowe also talked about how Australia has made little progress in reducing the amount of spare capacity in the economy. This particularly refers to unused or underused labour; what economists would call unemployment or underemployment.

As a result of the excess supply of labour, wages growth remains low. By cutting the cash rate, the RBA wants to see a fall in the level of underutilisation in the Australian economy (underutilisation rate = unemployment + underemployment).

Reason number three: Inflation remains below the target band

The RBA’s target band for inflation is 2-3 per cent over the course of the business cycle. Australia’s inflation rate hasn’t been within the target band, consistently for some years now (see graph below). 

Inflation hasn’t lived in the target band for some time now.

By cutting the cash rate, the RBA’s trying to boost inflationary pressures in the economy.

Willl this rate cut actually work?

As an economics student, you can question the effectiveness of monetary policy. The RBA’s had an expansionary stance for some years now and there hasn’t been a huge boost to growth or inflation. 

Another point to consider is that fiscal policy could do more, right now, to stimulate the economy. Is it appropriate to run contractionary fiscal policy (move to a surplus) when the RBA is trying to increase economic growth? They’re working against each other. This is a question worth asking. 

How should you allocate your time in the HSC?

According to the blurb on the front of the HSC Economics exam paper, this is how NESA thinks you should spend your time:

Don’t allocate your time this way. Source: NESA.

• Multiple choice: 35 minutes for 20 questions

• Short answer: 1 hour and 15 minutes for four questions

• Essays: 35 minutes for each essay.

I always wondered why they allocated the time this way. A smart teacher told me it was just NESA equally distributing the time (3 hours) across 100 marks. 

(180 minutes divided by 100 marks gives you 1.8 minutes per mark)

But these sections are NOT of equal difficulty. I think it is very hard to get an A-range response on the essays in only 35 minutes. You need more time here, and definitely less time on the multis.

Here’s how I suggest you allocate your time:

Multiple choice (do this first)

Maximum of 20 minutes here. Maybe less? Perhaps 15 would be ideal, but 20 minutes works okay.

Short answers (do this second)

Allocate 15 minutes per 10 mark question. All up, one hour for this section.

Essays (do this last)

Give yourself 50 minutes per essay. This is a much better allocation of time to try and access higher marks.

You have to be RUTHLESS about sticking to this timeline.

When you’re doing practice papers, use this timing and resist the temptation to go over. You’re just robbing time from another section!

Economic policies aren't perfect

You’re a government. And you’ve got problems. Economic problems. Serious economic problems that require serious solutions. So you want to use your policies: fiscal, monetary and microeconomic. But wait! They’ve all got limitations.

Limitation one: Time lags

No policy has an immediate effect. 

Here, we’ll distinguish between the implementation and effect of policies. The implementation refers to how long it takes to change a policy; effect is all about how long it takes the policy to affect the economy (change economic growth, inflation, etc).

Fiscal policy? It can be generally implemented once a year during the federal budget. And it can take effect quite quickly. Think about tax cuts: as soon as they are passed through Parliament, consumers will change their behaviour.

Monetary policy? The Reserve Bank of Australia meets once a month (except January), meaning the cash rate can be changed every month if required. So this policy can be implemented once a month. However, in terms of effect, monetary policy takes around 6 to 18 months to flow through the economy. So, longer than fiscal policy.

Microeconomic reform? It’s super complicated and expensive, so it can a long time to implement. And it could take decades to finish and have an impact on the economy. So long-term for both implementation and effect.

“Another thing to think about: governments want to be re-elected. So, they may not make tough policy decisions and be limited to safer, less controversial policies (which may not be the best for the economy).”

Limitation two: Political considerations

For fiscal policy and micro reform, the government might have to pass its changes through Parliament. If the government doesn’t have a majority in the Senate (ask me about this in the comments), they might have to compromise and scale back their plans to get them passed. This could limit the types of policies they can implement.

Another thing to think about: governments want to be re-elected. So, they may not make tough policy decisions and be limited to safer, less controversial policies (which may not be the best for the economy).

Monetary policy is conducted by the independent RBA so is free from political considerations.

Limitation three: Global factors

Governments may also face limitations in terms of what policies they can implement due to global conditions.

What do I mean?

One: there is a kind of global focus on specific policies, such as free trade, deregulation (labour markets, financial flows), free floating exchange rates and privatisation of government businesses. A government may face ‘peer pressure’ to follow these policies, even if wants to pursue an alternate policy.

Two: global economic conditions might dictate policy options. For example, there might be pressure on individual governments to run budget deficits during global downturns to support consumption and investment. This could risk plans for budget surpluses. 

Solving external stability

External stability is all about ensuring Australia can manage its financial relationships with other nations.

In practice, external stability is all about three questions:

1. Is the CAD too large?

2. Is the level of foreign debt too large?

3. Is the $A at an acceptable level?

Great. So how do we solve external stability?

“To improve external stability, the government could use fiscal policy to reduce the need for foreign debt by the public and private sectors.”

For all three questions, monetary policy (the Reserve Bank of Australia’s use of the cash rate to affect the level of economic activity) isn’t really useful. It’s too much of a blunt tool.

For example, using contractionary monetary policy to improve external stability will seriously slow the whole economy. Not a great outcome. (Ask me more about this in the comments.)

Let’s look at fiscal policy instead. This is the use of the federal budget to achieve economic objectives.

To improve external stability, the government could use fiscal policy to reduce the need for foreign debt by the public and private sectors.

For the public sector, the federal government could run budget surpluses (where taxation revenue exceeds government spending), create a nice pool of domestic savings for itself, which it can then use to fund investment — without having to call on (bring in) foreign capital.

So that will reduce the public sector part of foreign debt, and hopefully improve the CAD (less need for capital outflows, less primary income outflows). External stability improves!

For the private sector, the government could use fiscal policy to boost domestic savings by increasing the rate of compulsory superannuation.

Compulsory super is the Australian retirement scheme where employers are forced to put a portion of an employee’s wages into a retirement fund. The money cannot be touched until retirement. BUT! The superannuation funds, who hold the money, can invest it to earn a nice return for their members.

So a higher rate of compulsory super will increase the domestic pool of savings and again reduce the need for capital inflows to fund investment. Thus, external stability improves.

One more option. The federal government can try and make exports more competitive so Australia can sell more exports, put BoGS into surplus more often, and improve the CAD. The government can do this through microeconomic reform, supply-side policies that will allow firms to produce more at lower prices (represented by an increase in aggregate supply).

Or the government could do nothing. Capital inflows and a CAD are funding vital investment in Australia, that we could not otherwise fund. Why stop the party?

Who's in and out of the labour force?

As economists, the labour force is an important deal.

I grew sick of teaching it from scratch each year and instead filmed a lesson of me going through who’s in and who’s out (see below). It’s a bit messy but I think it works just fine. As a bonus, you’ll get a sneak peak into my eco classroom.

If you were going to use this, maybe as some pre-learning, I think it’d be valuable to get students to construct a very simple table with two columns:

• Column one: Who’s in (and why)

• Column two: Who’s out (and why)

By doing this first, you could have some more interesting discussions about the concept of the labour force in class, rather than using valuable class time to set out a series of accepted facts.

If you use this, please let me know how it goes!